The Sept. 18 article, ICI urging SEC to make soft dollar rules equal for all, mentions recent comment letters to the SEC, which request that regulators mandate and enforce a "level playing field" for regulations relating to the appropriate use of institutional clients' brokerage commission dollars.
The letters the article mentions were submitted by Elizabeth Krentzman, general counsel of the Investment Company Institute, and Henry Hopkins, chief legal counsel, T. Rowe Price Associates Inc. These letters request that regulators mandate that all advisers be prohibited from using soft dollars to acquire any services outside the safe harbor of Section 28(e) of the Securities Exchange Act of 1934. (The complete text of these comment letters can be seen at www.sec.gov/comments/s7-13-06/s71306.shtml.)
I believe that such a mandate would be the wrong approach for regulating the use institutional clients' brokerage commission. The correct approach to ensure all advisers treat their clients equitably in connection with their use of brokerage is to mandate disclosure and transparency in all institutional brokerage arrangements. All services provided by all brokerage firms and paid for by advisers should be defined and disclosed so consumers and regulators can determine which services qualify for the safe harbor of Section 28(e) and which services were acquired by fiduciaries using their professional investment discretion.
Such mandated unbundling and disclosure of brokerage services and client commission expenses would allow mutual fund directors, plan trustees and regulators to oversee institutional brokerage arrangements. It would also allow account owners and plan beneficiaries to evaluate if they are receiving the "direct benefit" from the uses of their commission dollars. This would create a much more efficient approach to oversight by allocating the benefits of oversight to those who are compensated for oversight (compensated either as fiduciaries, or as beneficiaries).
In her comment letter, Ms. Krentzman expresses a concern that advisers exempt from Section 28(e) or the requirements of ERISA might gain favoritism from brokerage firms because the advisers can spend clients' commission dollars in ways in which advisers required to comply with Section 28(e) and ERISA cannot. This concern seems disingenuous.
Section 28(e) was mandated by the U.S. Congress in 1975. Since then, to a large degree, the advisers and brokers who are required to comply with Section 28(e) have found various ways to ignore its requirements. Many of these advisers have continued to use institutional clients' brokerage commissions as the currency exchanged for brokerage favors. And, until recently, regulators have done little to restrain these abuses. The most popular approach for disguising the inappropriate use of clients' commissions is the bundled undisclosed institutional brokerage arrangement. In bundled undisclosed brokerage arrangements, the adviser agrees to add a significant premium to the commission paid in exchange for undisclosed favors. It's mutually understood that for the "premium," the adviser will receive "favors" from the broker. Some examples of favors that can be provided are: assistance selling managed products through the wirehouse network (shelf-space for the advisers' mutual funds, wrap account arrangements and separate account introductions); or consideration in the allocation of a hot new issue on its initial public offering, with the understanding that the stock can be "flipped" during the lock-up period. Or, the favor might be for the broker to facilitate an adviser by allowing a little late trading.
The lack of formal accounting, or, as its known in the industry, "disclosure and transparency," in bundled full-service brokerage arrangements prevents regulators, trustees and clients from knowing whether the various favors advisers receive constitute a breach of Section 28(e) compliance or a breach of the advisers' fiduciary duty. Furthermore, the lack of accounting also makes it difficult to determine if the clients whose commissions bought the favors receive the "direct benefit" for the commissions paid ("direct benefit" is one test of ERISA compliance).
Full disclosure of commissions paid by advisers and clear accounting of services provided by brokers would be a far better solution to the problem of institutional brokerage client commission abuse. Supreme Court Justice Louis Brandeis was on to something when he wrote in 1933: "Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policeman."
Bill George
consultant
Blue Sky Research Services LLC
Encino, Calif.
